Treasurys end lower as rate outlook debate rages

LeslieWines

NEW YORK (MarketWatch) -- Treasury prices ended lower Friday, sending yields higher, as investors debated whether or not a new Federal Reserve policy statement should be seen as signaling a 2007 rate cut.

Investors also took in news of an unexpected jump in existing home sales last month and the capture of British navy personnel by Iranian forces.

Treasury prices rose midweek on expectations that changes in the latest Federal Reserve monetary policy statement may pave the way for a rate cut in coming months.

The Fed Wednesday left the overnight rate unchanged at 5.25%. The central bank issued a policy statement that omitted a reference to "additional firming," a move widely seen as leaving the door open for a neutral bias and an eventual rate cut.

However, by Friday afternoon the implication of the change in wording and the rate cut scenario were under debate.

"Sentiment remains very bipolar on the direction of interest rates, with a 'coin toss' the prevailing consensus among dealers surveyed at the moment," said research firm Action Economics.

"Some see the unwinding of bullish bets set after the Federal Open Market Committee dropped 'any additional firming' from its lexicon as nearly complete, after being inappropriately equated with a drop in the tightening bias by one news service, which only added to the confusion," the economics firm said.

"Yet, others warn of a lack of a 'short base' on which to inspire a rally, while hoping that [Fed Chairman Ben] Bernanke's Joint Economic Committee testimony next Wednesdays may clarify the outlook," the firm said.

Analysts who doubt that a Fed rate cut is in the works point out that the central bank remains keenly focused on inflation and may keep rates higher to combat that threat.

The Fed's preoccupation with inflation risk was highlighted on Friday by new remarks from Philadelphia Federal Reserve President Charles Plosser. Plosser, in remarks to the New Jersey Bankers Association, said that recent inflation figures were "not encouraging."

Following the Fed decision on Wednesday, the yield on the 2-year note fell below the benchmark yield for the first time in 2007, marking the end to yield curve inversion.

The yield curve has been inverted for much of the past year, pushing yields on shorter-term maturities above those of longer-term maturities.

The inverted curve in essence removes the reward for making long-term loans. With an inverted yield curve, banks, hedge funds and other institutions can no longer make money by borrowing short-term money and lending it at longer terms.

Hopes that an easier interest rate policy will revive a slowing economy are expected to lead to further normalization of the curve.

"The action of the yield curve indicated an assessment of slower growth, stubborn inflation, and a policy that has the Fed in a more flexible position to react 'if necessary' to the data behavior in the months ahead," said analysts at Jefferies & Co.

In opening trade Friday Treasurys were lifted by safe-haven buying in the wake of news that 15 British sailors were in Iranian hands. British defense officials said the men and their boats were seized off the coast of Iraq after they inspected a merchant ship.

In midmorning, Treasurys gave up their gains after the National Association of Realtors said sales of existing homes unexpectedly rose 3.9% in February to a seasonally adjusted annual rate of 6.69 million. See full story.

The 3.9% gain was the largest since March 2004 and exceeded a MarketWatch prediction for a decline to about 6.35 million. Sales have risen three months in a row for the first time in three years.

The data soothed concerns that deterioration of the subprime mortgage market will further slow the housing market and hurt the economy. But indications of economic health dent interest in Treasurys.

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